| “Risk-Based Pricing of Interest Rates in Consumer Loan Markets” focuses on observable default risk's role in loan terms and the subsequent consequences for household behavior. The paper shows that lenders increasingly used risk-based pricing of interest rates in consumer loan markets during the mid-1990s. It tests three resulting predictions. First, the premium paid per unit of risk should increase. Second, debt levels should react accordingly. Third, fewer high-risk households should be denied credit, further contributing to the interest rate spread between the highest- and lowest-risk borrowers.; For those obtaining loans, the premium paid per unit of risk did indeed become significantly larger over this time period, with the difference between high- and low-risk borrowers' interest rates at least doubling for secured loans and increasing for most unsecured loans. For example, given a 0.01 increase in the probability of bankruptcy, the corresponding interest rate increase tripled for first mortgages, doubled for automobile loans and rose nearly six times for second mortgages. Additionally, changes in borrowing levels and debt access reflected these new pricing practices, particularly for secured debt. Borrowing increased most for the low-risk households least who were affected by these changes. Furthermore, while credit access increased for very high-risk households, the increases in their risk premiums implied that their borrowing as a whole either rose less or, sometimes, fell.; “Testing for Adverse Selection and Moral Hazard in Consumer Loan Markets,” explores unobservable default risk's significance in mortgage and automobile loan markets. A two-period model is presented allowing for heterogeneous forms of simultaneous adverse selection and moral hazard. Controlling for income levels, loan size and risk aversion, robust evidence of adverse selection is present. Borrowers self-select into contracts with varying interest rates and collateral requirements. For example, ex-post higher-risk borrowers pledge less collateral and pay higher interest rates. Moreover, there strongly suggestive evidence of moral hazard such that collateral is used to induce effort. Thus, loan terms may have a feedback effect on behavior. Also, higher-risk borrowers are more difficult to induce into exerting effort, explaining the counter-intuitive result that higher-risk borrowers sometimes pay lower interest rates than observably lower-risk borrowers. |
